ROC approach to forecasting recessions using daily yield spreads

Even though many studies have established the existence of structural breaks and declining predictability in the relationship between GDP growth and yield spreads, business analysts continue to watch for the inversion of the spread as one of the leading indicators for recessions. We use the Receiving Operating Characteristics (ROC) approach, to reevaluate the enduring power of spread to forecast recessions, notwithstanding the temporal instabilities. We identify the value of the spread that produces the highest discriminatory power as measured by different functionals of the ROC curve e.g., the hit rate, false alarm rate, and the Youden’s index. Based on data starting from January 2, 1962, we find that the optimal threshold has drifted upwards from zero since the early 1980s, and the deteriorating power of yield spread can largely be restored once the optimal cut-off values are used to issue recession forecasts.